City reform has got off to a good start.

Now for some real action

Bank reform: This may, just may, be the moment that the one-sided relationship between the City and the rest of us is at last recast
Will Hutton The Observer, Sunday 26 September 2010

The next 12 months promise to be the most decisive in recent financial history. On Friday the coalition's banking commission announced its presence with a much tougher and more comprehensive range of options for banking reform than anybody had expected. This may be the moment that the one-sided relationship between the City and the rest of us is at last recast. After the scale of the financial crisis we have lived through and the challenges ahead, the commission is hardly likely to settle for the status quo. Friday was a good start. Reform of the City has never greatly appealed to politicians of either left or right. Without the conviction and energy of business secretary Vince Cable who insisted upon the creation of a genuinely independent banking commission, the coalition would have been scarcely less feeble than its New Labour predecessor. After all, as City lobbyists never let us forget, the City of London is an international financial centre that generates 30bn of exports. At its peak in 2007 banks paid 27% of corporate taxes. This is a part of the British economy that allegedly works. Except that it has never come free. In October 2008 Britain was in the middle of a terrifying withdrawal of deposits from RBS that was in danger of spreading to the rest of the banking system with incalculable costs. It has taken 1.3 trillion of varying forms of support to get through the financial crisis and, on top of that figure, cumulatively Britain will suffer more than a 1 trillion of lost output. What is now needed is a financial system that will engage with its economic hinterland to help create a more balanced diversified economy and propel economic growth. Britain does not possess such a system. Instead, our bankers, like those worldwide, are drawn towards the demi-monde of investment banking with its stupendous profit margins and bonuses; the two new CEOs of HSBC and Barclays have both been recruited from their respective investment banking divisions. But this world of shadow banking and trading of barely understood financial instruments that are worth many times world GDP is inherently risky and shot through with endemic conflicts of interest well understood by the banks who make the markets, where distrust is rampant. Any hint of fragility and dispatch is fast and lethal threatening a chain reaction that could once again bring down the entire financial system. The risk of another crisis is hard-wired into the DNA of contemporary finance. There must be reform, and today represents a unique conjunction of events and people that may bring it about. For Vince Cable is not alone in his concern both about the systemic vulnerability of the banking system and its bias against business lending. The governor of the Bank of England is no less passionate; and so is the chair of the Financial Services Authority, Adair Turner. Never before have a senior politician and top monetary officials been so like-minded on the case for City reform. Moreover, Cable is in a position of enormous strength. His coalition partners are wedded to an unfolding political drama and unparalleled economic austerity, wanting to cut the budget deficit as brutally quickly as they do. This may be bad news on many fronts, but it is great news for banking reform. The coalition's plummeting poll ratings next year will coincide with the banking commission's conclusions. The bankers have understood that they must deploy much more core capital to underwrite their activities. They also accept the Financial Services Authority requirement that 60% of bonuses should be deferred for up to three years. But they are resolutely opposed to any more reform, especially any separation of commercial banking from even a small amount of the most speculative investment banking. They openly threaten to leave the country if any such policy is championed. But such threats only dramatise the gulf that has opened between bankers' definition of their interests and any conception of the public interest. In any case where would they go? The rest of the world is no more interested than is Britain in hosting megabanks who jealously want to retain the privilege to speculate as they choose with host country taxpayers picking up the pieces. Switzerland is too small to accept another megabank, having been nearly overwhelmed in 2008. Same story for Hong Kong. Barclays will also hesitate to jump into the arms of the US's formidable regulators, reinforced by the new Dodd-Frank act along with America's litigation culture, by headquartering in New York. Britain remains the best bet. Instead of resisting structural reform, the banks would be much cleverer to accept there is a problem and open up the argument. An important reason why British banks behave as they do is because of the
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way the Bank of England runs the banking system. Unlike other leading central banks it refuses to buy commercial loans off the banks when they are in a corner, saying such purchases would be "political", favouring one commercial borrower over another. But doing nothing is no less political. Because they know they are on their own, British banks guard against risk by collateralising every loan against property and grow as big as they can to diversify that risk. The result is megabanks, property bubbles, minimal business lending and a banking system than has become uniquely systemically vulnerable. There is a case for breaking up our very biggest banks, especially Lloyds, in a British trust-busting moment and limiting their speculative proclivities along American lines. But that alone will not create a more competitive banking system that backs British business. For that the whole system needs recasting, including the actions of the Bank of England. I hope the banking commission thinks this big. This is a once-in-a-century opportunity for reform. To funk it would be to let everyone down.